Citigroup Inc. and Deutsche Bank AG are leading banks offering the debt to investors in the mid-80 cent range, down from 90 cents to 91 cents last week, said the people, who declined to be identified before the loans are sold.

The price cut reflects a decline in average actively traded loans. Prices fell to 89.9 cents on the dollar from 92.1 on June 19, the first time it dipped below 90 cents since April, according to data compiled by Standard & Poor’s LCD. The discounting indicates that a rally in loan prices in April and May has ended.

Another horrible day to end a horrible month. CPD is down about 4.26% on the month; MAPF is down between 6.25% and 6.50% – I will have precise figures tomorrow.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30

Index

Mean Current Yield (at bid)

Mean YTW

Mean Average Trading Value

Mean Mod Dur (YTW)

Issues

Day’s Perf.

Index Value

Ratchet

4.25%

3.86%

47,247

0.08

1

-0.0786%

1,118.4

Fixed-Floater

4.89%

4.64%

60,867

16.05

7

-1.3351%

1,029.1

Floater

4.24%

4.24%

70,790

16.91

2

-0.7533%

903.8

Op. Retract

4.88%

2.93%

202,484

2.80

16

-0.1206%

1,052.9

Split-Share

5.39%

6.04%

65,282

4.11

15

-0.0894%

1,036.4

Interest Bearing

6.13%

3.53%

46,393

2.00

3

-0.1656%

1,122.7

Perpetual-Premium

5.94%

4.70%

319,249

11.09

13

-0.1721%

1,011.4

Perpetual-Discount

6.02%

6.07%

218,423

13.82

59

-0.3707%

877.2

Major Price Changes

Issue

Index

Change

Notes

BNA.PR.C

SplitShare

-4.7425%

On zero volume, as the bids just disappeared and it closed at 18.05-00, 7×5 (great market making!). Asset coverage of just under 3.6:1 as of May 30 according to the company. Now with a pre-tax bid-YTW of 8.48% based on a bid of 18.05 and a hardMaturity 2019-1-10 at 25.00. Compare with BNA.PR.A (6.00% to 2010-9-30) and BNA.PR.B (8.63% to 2016-3-25).

BCE.PR.C

FixFloat

-4.4613%

NA.PR.K

PerpetualDiscount

-3.3319%

Now with a pre-tax bid-YTW of 6.40% based on a bid of 23.21 and a limitMaturity.

BCE.PR.A

FixFloat

-3.0833%

WFS.PR.A

SplitShare

-2.9819%

Asset coverage of just under 1.7:1 as of June 19, according to Mulvihill. Now with a pre-tax bid-YTW of 8.75% based on a bid of 9.11 and a hardMaturity 2011-6-30 at 10.00.

BCE.PR.R

FixFloat

-2.0851%

BCE.PR.G

FixFloat

-2.0888%

CM.PR.P

PerpetualDiscount

-1.8936%

Now with a pre-tax bid-YTW of 6.32% based on a bid of 21.76 and a limitMaturity.

BAM.PR.K

Floater

-1.5377%

GWO.PR.H

PerpetualDiscount

-1.4464%

Now with a pre-tax bid-YTW of 6.18% based on a bid of 19.76 and a limitMaturity.

ELF.PR.G

PerpetualDiscount

-1.4428%

Now with a pre-tax bid-YTW of 6.72% based on a bid of 17.76 and a limitMaturity.

HSB.PR.C

PerpetualDiscount

-1.3744%

Now with a pre-tax bid-YTW of 6.17% based on a bid of 20.81 and a limitMaturity.

CM.PR.E

PerpetualDiscount

-1.3010%

Now with a pre-tax bid-YTW of 6.15% based on a bid of 22.76 and a limitMaturity.

HSB.PR.D

PerpetualDiscount

-1.2255%

Now with a pre-tax bid-YTW of 6.25% based on a bid of 20.15 and a limitMaturity.

PWF.PR.K

PerpetualDiscount

-1.2136%

Now with a pre-tax bid-YTW of 6.20% based on a bid of 20.35 and a limitMaturity.

PWF.PR.L

PerpetualDiscount

-1.0849%

Now with a pre-tax bid-YTW of 6.20% based on a bid of 20.97 and a limitMaturity.

BAM.PR.O

OpRet

-1.0417%

Now with a pre-tax bid-YTW of 6.24% based on a bid of 23.75 and optionCertainty 2013-6-30. Compare with BAM.PR.H (5.06% to 2012-3-30), BAM.PR.I (5.47% to 2013-12-30) and BAM.PR.J (5.92% to 2018-3-30).

BCE.PR.G

FixFloat

+1.1111%

RY.PR.F

PerpetualDiscount

+1.1206%

Now with a pre-tax bid-YTW of 5.96% based on a bid of 18.95 and a limitMaturity.

SBN.PR.A

SplitShare

+1.6162%

Asset coverage of 2.2+:1 as of June 19, according to Mulvihill. Now with a pre-tax bid-YTW of 5.19% based on a bid of 10.06 and a hardMaturity 2014-12-1 at 10.00.

Volume Highlights

Issue

Index

Volume

Notes

TD.PR.P

PerpetualDiscount

105,399

Nesbitt sold 64,000 to National Bank in two tranches at 23.05, then another 37,900 to “anonymous” in another two tranches at the same price. Now with a pre-tax bid-YTW of 5.80% based on a bid of 23.01 and a limitMaturity.

TD.PR.Q

PerpetualDiscount

55,505

Nesbitt crossed 50,000 at 24.80. Now with a pre-tax bid-YTW of 5.74% based on a bid of 24.80 and a limitMaturity.

BMO.PR.J

PerpetualDiscount

37,000

CIBC crossed 30,000 at 19.26. Now with a pre-tax bid-YTW of 5.93% based on a bid of 19.25 and a limitMaturity.

SLF.PR.A

PerpetualDiscount

20,600

Nesbitt crossed 17,000 at 20.10. Now with a pre-tax bid-YTW of 5.97% based on a bid of 20.05 and a limitMaturity.

NA.PR.K

PerpetualDiscount

13,200

Now with a pre-tax bid-YTW of 6.40% based on a bid of 23.21 and a limitMaturity.

There were five other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Since banks and insurers are regulated as to their safety and soundness, a “Reputationally Supported” or RS product would clearly have more value than a product that isn’t. A great example of this product is a money market fund. Banks around the world have essentially already committed not to “break the buck” and many here in Canada have gone to extreme lengths not to price these funds below $10. Other products such as straight equity funds and various structured products probably wouldn’t carry the RS brand.

I’m not saying that banks couldn’t sell the riskier products (as that would limit customer choice), I am just saying that we try to more clearly brand the product so the degree of support by the seller is apparent. If the bank wants to sell no RS branded products, so be it.

We both have the objectives of forcing banks to recognize their de facto exposure to branded Money Market Funds as an element of their balance sheet risk. Mr. de Verteuil proposes formalizing the process with an explicit “Reputationally Supported” moniker that would be assigned by the banks; my proposal does not include such formality but states that, for instance, “RBC Canadian T-Bill Fund” is reputationally supported by RBC simply due to the fact that they put their name on it.

An old thread regarding preferreds has come to life on Financial Webring Forum, with one poster speculating that the Swoon In June is tax-driven – there are two tax changes scheduled to have an effect on preferreds in the next few years, Federal Bad and Ontario Good, netting out to a modest negative.

It is my feeling that the recent decline is driven more by portfolio window-dressing by retail stockbrokers more than any fundamental factor.

If fundamental factors were to blame – or even if they were fundamental factors mis-applied! – I would expect to see that the market would retain some degree of internal consistency.

This is not what’s happening. Deeply-discounted perpetuals are being hit harder than slightly-discounted perpetuals (the discount of market price relative to potential call price, that is) – I gave the example of the CM issues on June 26 and two RY issues more recently.

This has happened to the extent that deeply discounted perps yield more than slightly-discounted perps. This simply should not happen (see the links in the June 26 post) and, I will emphasize, is not due to any historic spread relations or anything like that … the causation is the other way round. Convexity is a pretty basic fixed-income analytical tool, with a negligible effect for normal bonds, but a huge factor in callables (or other type of embedded option).

You can, if you like, make an argument that convexity has zero value and that therefore any perpetual discount from a given issuer should trade at the same yield, regardless of its combination of price and dividend. I might laugh at your pathetic little arguments, but you can make them with some semblance of rationality. But it is not possible to argue that convexity has a negative value and that therefore a discounted perpetual with a relatively high coupon should trade at a lower yield than its lower-coupon, otherwise identical, sibling. There might possibly be other things going on that would lead to that effect – but it wouldn’t be a direct effect and I haven’t been able to come up with any actual evidence that such an effect is even remotely possible.

The fact that it has happened anyway has convinced me that it’s retail window-dressing. We are approaching quarter-end and stockbrokers do not want to remind their clients, yet again, that the new issue they bought at $25 is now trading at $20. So, of the two or three issues in the client’s portfolio, they sell the lowest priced one, regardless of yield.

It’s only a hypothesis and it’s completely untestable … but I have not been able to think of anything else!

The fact that the relative prices are out of whack – and not based on any kind of normal fixed-income analysis – causes me to be very suspicious of the fundamental underpinnings of the overall decline.

If we plug in the projected Ontario tax rate on dividends for 2012 of 26.7% and the projected rate on income of 46.41%, we arrive at an equivalency factor of (1-0.267)/(1-0.4641) = 1.37. This is marginally lower than current, but PerpetualDiscounts now yield 6.04%, while long corporates are about 6.1%. Even the lower equivalency factor results in a spread of about 215bp, well in excess of historical norms and very hard to justify in fundamental terms (although, it should be noted, you can always justify anything you like in fundamental terms).

When the market re-establishes some degree of internal consistency (as far as the pref market ever is internally consistent!) we can have a look and see what the spreads really are. Until then, the situation is too clouded by clear signs of panic to allow any conclusions to be drawn.

Just doing a little playing around … and thinking of today’s market commentary … and I thought I’d post a few graphs regarding these two issues, taking data from the last approximate trough of November 30, 2007 until now.

“Disparity” is a proprietary HIMIPref™ measure of rich/cheap. It is not the same thing as valuation … but it is very influential in this calculation. It should be noted that in the above graphs, the disparity is calculated according to the pre-tax yield curve, which I never use for valuation purposes. So caveat lector … just enjoy the trends!

Whenever ECB interest rates become inappropriately low for a member state, for example, aggressive reductions in tax breaks on housing should aim to reduce the stimulus coming from ECB policy. For example, mortgage interest relief could be conditional on the real rather than the nominal interest rate. At the same time, tax incentives that favour fixed- over flexible-rate mortgages might be called for, as well as changes to the property tax and capital gains tax regime so that they act automatically as countercyclical stabilisers. In some cases, additional temporary tax measures to contain an emerging bubble will be required.…All told, the three Divisions have examined the references to credit ratings in 44 of our rules and forms. The staff is recommending changes to 38 of them. Specifically, they are recommending the complete elimination of any reference to credit ratings in 11 rules and forms. They are recommending the substitution of a standard based on a more clearly stated regulatory purpose or other concept in 27 rules and forms. And they are recommending leaving the reference unchanged in 6 rules and forms.

Trouble is, bubbles are only apparent after the fact. And there is no evidence to suggest that, ultimately and in aggregate, the Wise Men have any better an idea of how to accomplish market-timing than anybody else. Canada, for example, can be thought of as resembling the EU to some extent, in that our different regions have very different economies – we periodically hear massive complaints about monetary policy, for instance, tightening when a particular region is already in the doldrums. Can you imagine the reaction to special taxes and mortgage regulation in response to, say, Calgary’s oil-fueled housing boom?

The third part of this rulemaking, which we take up today, is focused on the way the Commission’s own rules refer to and rely upon credit ratings. For some time before the recent subprime crisis, we had been re-evaluating the basis for the SEC’s use of ratings as a surrogate for compliance with various regulatory conditions and requirements. The recent market turmoil, and the role that credit ratings played in it, has only further motivated our consideration of reform in this area.

To begin with, the SEC’s own rules don’t distinguish between ratings for corporate bonds and ratings for structured finance products. As a result, our own regulatory regime might be vulnerable to criticism on the same grounds as the ratings agencies’ use of common symbology: namely, that it doesn’t properly reflect the different risk characteristics of structured products, and the different kinds of information and ratings methodologies that go into ratings for structured products.

Second, several of our regulations implicitly assume that securities with high credit ratings are liquid and have lower price volatility.But since structured finance products can be very different from other rated instruments in these respects, there is good reason for us to examine the precise way that credit ratings are used in our rules as a surrogate for measurements of liquidity and volatility.

Third, several observers, including the Financial Stability Forum, have leveled the criticism that the official recognition of credit ratings for a variety of securities regulatory purposes may have played a role in encouraging investors’ over-reliance on ratings.

Elizabeth Duke, a Virginia banker, was confirmed today by the Senate to a seat on the Federal Reserve Board of Governors, breaking a yearlong impasse between the Bush administration and Congress.…Duke, who has been a banker for more than 30 years, was the first woman to chair the American Bankers Association, the industry’s Washington trade group, since its founding in 1875. She served as chairman from 2004 to 2005 and was on its board of directors from 1999 to 2006.

Duke served on the Richmond Fed bank’s board from 1998 to 2000. “She made great contributions then, and I know she’ll make tremendous contributions to the system now,” said Jeffrey Lacker, the bank’s president, who was research director at the time.…Duke held at least $8.2 million in assets, including more than $5 million of stock in Wachovia, according to a financial- disclosure filing last year. Fed officials are required to divest themselves of bank shares.

Well … her shares in Wachovia are probably worth less now! Every little bit helps!

The Belgian-Dutch financial services group was forced to take what it called “exceptional measures” by tough market conditions as well as its purchase of parts of its former Dutch rival ABN AMRO, sealed just as the credit crisis hit last year.

It said it would sell about 6 per cent more shares to institutions to raise €1.5-billion, plus up to €2-billion of non-dilutive preference shares. It will save €1.3-billion by not paying an interim 2008 dividend, sell €2-billion of non-core assets and sell and lease back real estate, and pay its full-year dividend in shares.

In the comments to June 26, Assiduous Reader prefhound professed himself insufficiently impressed by the +31bp spread between CM.PR.E & CM.PR.J to take a position.

So I’ll try again … the RY issues aren’t as good a sample, since most of them come with very, very similar coupons. But how about if we just look at the two yield extremes:…

Two RY Perpetuals

Issue

Dividend

Quote

Pre-TaxBid-YTW

RY.PR.F

1.1125

18.74-98

6.02%

RY.PR.W

1.225

22.23-33

5.58%

Ha! +44bp when it should be negative! How about them apples, prefhound?

Another way to look at is that the difference in dividend is $0.1125 and the difference in bid price is $3.49 … payback time just over 31 years. Don’t show such investments to your accountant.

Now, whenever anybody wants to make an argument about, say, PWF being a significantly better/worse credit than SLF … go for it! Maybe I’ll learn something! And we can certainly discuss at length just how much yield premium is required to hold a preferred with a limited upside (aka negative convexity). Hey, make a case that it should be zero! I’ll listen! But if anybody were to tell me that the yield premium really should be significantly negative, as it was with the CM issues today and as it is with these two RYs … it will probably be a short conversation! The only things I can think of – given that the issuer is the same – are:

A big difference in term to call

A big difference in liquidity

A big difference in other terms of the issue (e.g., voting rights, restrictive covenants, etc.)

None of these differences are applicable with the CM & RY issues I’ve highlighted. This is a very, very strange market.

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30

on or prior to June 27, 2008, it received notices in respect of 744,124 of its remaining 2,507,153 issued and outstanding Series 5 Cumulative Redeemable First Preferred Shares (TSX: IQW.PR.C) (the “Series 5 Preferred Shares”) requesting conversion into the Company’s Subordinate Voting Shares (TSX: IQW).

In accordance with the provisions governing the Series 5 Preferred Shares, registered holders of such shares are entitled to convert all or any number of their Series 5 Preferred Shares into a number of Subordinate Voting Shares effective as of September 1, 2008 (the “Conversion Date”), provided such holders gave notice of their intention to convert at least 65 days prior to the Conversion Date. The Series 5 Preferred Shares are convertible into that number of the Company’s Subordinate Voting Shares determined by dividing Cdn$25.00 together with all accrued and unpaid dividends on such shares up to August 31, 2008 by the greater of (i) Cdn$2.00 and (ii) 95% of the weighted average trading price of the Series 5 Preferred Shares on the Toronto Stock Exchange during the period of twenty trading days ending on August 28, 2008.

The next conversion date on which registered holders of the Series 5 Preferred Shares will be entitled to convert all or any number of such shares into Subordinate Voting Shares is December 1, 2008, and notices of conversion in respect thereof must be deposited with the Company’s transfer agent, Computershare Investor Services Inc., on or before September 26, 2008.

This continuing conversion shows the value (to the company, and to the existing common shareholders) of the use of a minimum price to avoid ‘death spiral’ conversion. The last price of IQW.PR.C is $1.65; the last price of the IQW is $0.185 … but the face value ($25.00) plus accumulated dividends of IQW.PR.C is used as the numerator in the conversion, with the minimum of $2.00 per common share used as the denominator. In the last conversion, the ratio was 13.146875 common per preferred converted.

It has long been a criticism of the structural Merton models of default that they calculate credit spreads that are much lower than those observed in the market. The Bank of England and the Bank of Canada take what I feel is a sensible course and ascribe the excess spread to liquidity concerns.

Liquidity, however, is a kind of touchy-feely concept and there is a yearning to quantify credit spreads such that, ideally, every single beep could be assigned to some kind of rational formula, base largely on default probability. In the Bank of Canada paper referenced above, the authors note:

Recent research that expands structural models by including them in a broader macroeconomic setting has shown that credit-risk premiums may, in fact, account for a larger portion of the overall spread than indicated by the “traditional” structural model (Chen 2008). This suggests that the results of “traditional” structural models such as that used in this study should be interpreted with caution, and should focus on the direction in which risk factors evolve, rather than on the specific values of the relative contributions of the factors.

This paper addresses two puzzles about corporate debt: the “credit spread puzzle” – why yield spreads between corporate bonds and treasuries are high and volatile – and the “under-leverage puzzle” – why firms use debt conservatively despite seemingly large tax benefits and low costs of financial distress. I propose a unified explanation for both puzzles: investors demand high risk premia for holding defaultable claims, including corporate bonds and levered firms, because (i) defaults tend to concentrate in bad times when marginal utility is high; (ii) default losses are also higher during such times. I study these comovements in a structural model, which endogenizes firms’ financing and default decisions in an economy with business-cycle variation in expected growth rates and economic uncertainty. These dynamics coupled with recursive preferences generate countercyclical variation in risk prices, default probabilities, and default losses. The credit risk premia in my calibrated model are large enough to account for most of the high spreads and low leverage ratios. Relative to a standard structural model without business-cycle variation, the average spread between Baa and Aaa-rated bonds rises from 48 bp to around 100 bp, while the average optimal leverage ratio of a Baa-rated firm drops from 67% to 42%, both close to the U.S. data.

He points out:

One can not resolve the puzzles simply by raising the risk aversion. While a higher risk aversion does push up the credit spreads, it increases the equity premium dramatically. Moreover, a higher risk aversion actually increases the leverage ratio. It does increase the expected costs of financial distress, which leads to lower optimal coupon rate lower and higher interest coverage. However, a drop in debt value comes with a bigger drop in equity value, resulting in a higher leverage ratio.

The guts of the argument is:

First, marginal utilities are high in recessions, which means that the default losses that occur during such times will affect investors more. Second, recessions are also times when cash flows are expected to grow slower and become more volatile. These factors, combined with higher risk prices at such times, imply lower continuation values for equity-holders, which make firms more likely to default in recessions. Third, since many firms are experiencing problems in recessions, asset liquidation can be particularly costly, which will result in higher default losses for bond and equity-holders. Taken together, the countercyclical variation in risk prices, default probabilities, and default losses raises the present value of expected default losses for bond and equity-holders, which leads to high credit spreads and low leverage ratios.

Frankly, I don’t consider the paper very satisfying. While the argument appears sound, the actual model is too highly parameterized to allow for high confidence in the outputs; in other words, I fear that a variation of data mining has come into play. Additionally, I am highly suspicious of arguments that assume the market is rational and that an objective evaluation of default risk is (essentially) the only factor determining credit spreads. That’s not what I see in the market.

What I see is a lot of segmentation (some investors will not buy corporates. Some investors will buy corporates, but will dump and run at the first whiff of difficulties) and a high liquidity premium – these are two factors not considered in the model.

The authors first define their terms, making a basic point that surprisingly few investors understand:

In general, two important components drive variations in corporate yield spreads. One is the expected loss from default, the other relates to risk premiums. This latter component can be further decomposed into two types: a credit-risk premium and an illiquidity premium. The expected loss from default generally reflects the fundamentals of the firm, such as the degree of leverage and its ability to generate a stable stream of profits. The credit-risk premium is related to the variability of, or uncertainty about, potential loss from default. Both the credit-risk premium and the expected loss from default are affected by changes in macroeconomic activity. When combined, these two components comprise the part of the yield spread attributed to default-related credit risks.

The illiquidity premium, a non-credit-risk factor, relates to a lack of general market liquidity. Moreover, the credit-risk and illiquidity premiums, like other risk premiums, can vary with any change in the risk appetite of investors and are therefore likely to be positively correlated over time.

They decompose the components of the corporate spread vs. governments using a structure “Merton” model, very similar to the BoE research previously reported on PrefBlog – the BoE is thanked for supplying code in note 16. For investment-grade firms issuing Canadian Corporate Bonds (they do not define their universe more precisely than this) they conclude:

As of 21 May 2008, while the actual spread was 179 basis points, the expected loss, credit-risk premium, and illiquidity premium were 20, 34, and 125 basis points, respectively. Comparable figures for end-July 2007 were 85, 21, 5, and 59 basis points, respectively. The increase in the investment-grade credit spread can thus be attributed to an increase in the credit-risk and illiquidity premiums above their recent historical norms.

… while noting:

The credit-risk component reached its peak level of 89 basis points in March 2008, and the illiquidity premium reached its peak level of 125 basis points in May 2008.

Much of the increase is due to the “high proportion of financial firms (approximately 55% of the index in 2007).”

Yield Calculation Conventions

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